Complex rules burden outbound transfers of tangibles and intangibles.

• Author: Albaugh, William E.

For more than 60 years, Congress has been concerned with the tax-free transfer of appreciated property to foreign corporations, enacting a number of provisions over that time to ensure that such transfers are denied gain nonrecognition treatment. While the general purpose of Sec. 367 and the regulations thereunder i$ merely to ensure that the U.S. maintains taxing jurisdiction over such transfers, this article suggests that these rules surpass their intended purpose in many situations.

The general intent of Sec. 367 is to preserve U.S. taxing jurisdiction over appreciated property transferred to foreign corporations in certain tax-deferred exchanges. Prior to the enactment of the predecessor to Sec. 367 in 1932, Congress perceived a "serious loophole"(1) with respect to built-in gain property transferred outside of the U.S. in nontaxable exchanges. Sec. 367(a)(1) provides that if property is transferred by a U.S. person to a foreign corporation in an exchange described in Sec. 332,(2) 351, 354, 356 or 361, the corporation will not be treated as a corporation for gain recognition purposes (but losses remain deferred under the relevant nonrecognition provision). The effect is to negate nonrecognition treatment through the denial of corporate status to the foreign transferee, a critical element in qualifying for such treatment under these provisions. Exceptions are provided for certain (1) transferred property to be used by the foreign transferee in the active conduct of a trade or business outside of the U.S. and (2) transfers of stock or securities if the U.S. transferor(s) satisfies enumerated ownership tests and other requirements.

The Tax Reform Act of 1984 (TRA '84), Section 131(b), enacted Sec. 367(d) to address separately certain outbound transfers of intangibles under Secs. 351 and 361. Essentially, this provision treats the U.S. transferor(s) as having sold the intangible for a series of annually determined U.S.-source payments. Section 1231(e)(2) of the TRA '86 added the "commensurate with income" (CWI) standard to Sec. 367(d), which requires the U.S. transferor's annual deemed payments to reflect an amount contingent on the productivity, use or disposition of the intangible in the hands of the foreign transferee. This article summarizes the legislative history and current statutory and regulatory authorities dealing with outbound transfers under Sec. 367.(3)

Outbound Transfers of Stock or Securities

Prior to the enactment of the predecessor to Sec. 367, certain perceived abuses existed relating to outbound transfers of stock or securities:

Example 1(4): A, an American citizen, owns 100,000 shares of stock in corporation X with a basis of $1,000,000 and a fair market value (FMV) of $10,000,000. Instead of selling the stock outright, A organizes corporation C under the laws of Canada, then transfers the 100,000 X shares for C's entire capital stock in a nontaxable exchange. C sells the X stock for 310,000,000. The latter transaction is exempt from tax under Canadian law and is not taxable in the U.S. C organizes U.S. corporation Y and transfers the $10,000,000 received on the sale of the X stock for the entire capital stock of Y. C then distributes the Y stock to A in connection with a reorganization. By this series of transactions, A has had the X stock converted into cash and now has it in complete control.

Since 1932, many provisions (in addition to Sec. 367) have been added to the Code to battle such abuses. For instance, in the above example, C's disposition of the X stock would currently result in a subpart F inclusion to A under Sec. 954(c)(1)(B)(i). Also, under Sec. 956(c)(1)(B), the mere holding of X stock under the facts of the example would potentially produce a deemed dividend to A. With the enactment of these and other related provisions,(5) it might reasonably be argued that, in many cases, Sec. 367 has surpassed its intended purpose of preserving U.S. taxing jurisdiction over outbound transfers of built-in gain property.

Legislative Overview

As originally enacted, Sec. 112(K) (the predecessor to Sec. 367) provided that a U.S. transferor had to obtain a favorable ruling prior to an outbound transfer to a foreign corporation under Sec. 332, 351, 354, 355, 356 or 361, concluding that the principal purpose of the transfer was not tax avoidance, for the foreign transferee to be treated as a corporation. Rev. Proc. 68-23(6) contained the first set of comprehensive guidelines indicating when such favorable rulings would be issued, although the U.S. transferor continued to be denied a judicial remedy to the extent an adverse IRS determination was issued.(7) In addressing this issue, the Tax Reform Act of 1976 (TRA '76), Section 1042(d)(1), added former Sec. 7477, which allowed taxpayers to petition the Tax Court for declaratory judgments after all administrative remedies had been exhausted. The TRA '76 also allowed U.S. transferors to delay a ruling request until 183 days after the initial transfer. Section 131(e)(1) of the TRA '84 repealed the mandatory ruling procedure under Secs. 367 and 7477 altogether.

In May 1986, temporary regulations(8) (1986 regulations) were issued dealing in part with outbound transfers of stock or securities. Due to concerns that these regulations were overly complex and failed to provide coherent guidance, the IRS issued Notice 87-85(9) (generally effective for transfers occurring after Dec. 16, 1987), which, for the most part, repealed the 1986 regulations, except for those dealing with "gain recognition agreements" (GRAB) (discussed below). Notice 87-85 stated that new regulations would be issued providing for exceptions to gain recognition under Sec. 367 for outbound transfers of stock or securities of both foreign and domestic corporations based on the U.S. transferor's ownership in the foreign transferee immediately after the exchange. In August 1991, the IRS published two sets of proposed regulations (1991 regulations): one set dealt with outbound transfers under Sec. 367(a)(10) by incorporating the changes previously announced in Notice 87-85; the other addressed inbound so-called "foreign-to-foreign" transfers under Sec. 367(b).(11) Notice 94-46(12) (effective for transfers occurring after Apr. 17, 1994) effectively overrode Notice 87-85 with respect to outbound transfers of domestic stock or securities. Notice 94-46 also provided that final regulations would be issued to deny nonrecognition treatment for certain outbound transfers of domestic stock. Temporary regulations(13) under Notice 94-46 were issued in December 1995 (1995 temporary regulations). These regulations were finalized in December 1996 (1996 final regulations); the latter contains slight modifications to the 1995 temporary regulations.(14)

Under Notice 87-85 and the Sec. 367(a) 1991 regulations. nonrecognition treatment to U.S. transferors with respect to outbound transfers of foreign (and domestic) stock was based principally on the U.S. transferor's ownership in the foreign transferee (applied on a transferor-by-transferor basis). If such ownership (measured by vote and value) in the foreign transferee was less than 5% after taking into account the Sec. 958 attribution rules, gain recognition was not required.(15) If ownership in the foreign transferee was at least 5%. gain recognition could generally be avoided only if the U.S. transferor(s) entered into a five-year (if the foreign transferee was not U.S.-controlled) or 10-year (if the foreign transferee was U.S.-controlled) GRA with the IRS.(16) However, gain recognition was required under Notice 87-85 if (1) on transfers of domestic stock a particular U.S. transferor owned more than 50% of the foreign transferee immediately after the transfer, or (2) a U.S. transferor transferred stock in a controlled foreign corporation (CFC)(17) to a foreign transferee that was either (a) not a CFC immediately after the exchange or (b) a CFC immediately after the exchange, but the U.S. transferor was no longer a "U.S. shareholder."(18)

The first exception to nonrecognition, also contained in Prop. Regs. Sec.1.367(a)-3(b)(3), was intended to prevent U.S. corporate transferors from...